Think Twice About These 2 Bond ETFs

Beware the rallying long end of the fixed-income market.

Underpinned by a lackluster recovery, low inflationary pressure and geopolitical unrest in Ukraine, long- dated bonds that serve as a safe haven have enjoyed an impressive rally in the first quarter of 2014.

In particular, the Pimco 25+ Year Zero Coupon U.S. Treasury Index Exchange-Traded Fund (ZROZ | C-51) and the Vanguard Extended Duration Treasury ETF (EDV | C-39) have absolutely crushed everything in the bond ETF universe. Both exclusively target the zero-coupon Treasury bond space.

As of April 25, ZROZ and EDV have returned almost 19 percent and more than 17 percent, respectively, while the S&P 500 Index has returned less than 1 percent.

For now, the bullish bond dynamic that prevailed in the first quarter is still in place, as investors worry about how and when the Russia-Ukraine crisis will resolve and as they respond to the Federal Reserve’s latest pledge to keep short-term interest rates pinned at near-zero levels. But that only serves to add to anxiety about how swiftly ZROZ and EDV are likely to correct once sentiment reverses.

Mean-Reverting Tendency: What Goes Up Must Come Down

But given the continuing improvements in the economy and a general expectation of rising rates, ZROZ and EDV are unlikely to repeat their impressive performance. So don’t chase performance.

Still, it’s nonetheless beneficial to understand the unique structure, tax advantage and the source of performance of a zero-coupon Treasury ETF in case you want to make a long-duration bet or need a viable flight-to-safety vehicle in response to a geopolitical event in the future.

Zero-Coupon Treasury Bond

A regular coupon-bearing Treasury bond basically has two components: the principal (paid in full at maturity); and coupons (periodic interest payments).

A zero-coupon Treasury bond is created by stripping out the coupons of a coupon-bearing Treasury bond into a separate income stream. The resulting product—a zero bond—is traded as a separate security. A zero bond doesn’t provide periodic interest payments; it only repays bondholders the full face value at maturity.

Because of the lack of periodic cash flows and the inverse relationship between a bond’s price and its yield, a zero-coupon bond usually trades at a deep discount to its face value to generate comparable yields to its coupon-bearing counterparts. As the zero bond bought at discount matures, its price will appreciate gradually—accretion—to its face value.

The Phantom Income

Accretion is considered a form of interest income by the Internal Revenue Service even though no cash is actually received until maturity. What this means is that despite not having actual cash income before maturity, bondholders still need to pay federal income tax on accretion—commonly referred to as phantom income—on an ongoing basis. As such, holders of zero-coupon bonds still need to set aside cash in advance to meet those ongoing tax payments.

Zero-coupon Treasury ETFs offer broad exposures and tax liability management in one package, with an annual expense ratio of less than 15 basis points ($15 for each $10,000 invested). Conveniently, notwithstanding the lack of ongoing interest income from bonds, both ZROZ and EDV make quarterly distributions that investors can use to match their tax payments.

Portfolio managers (PMs) often use simple accretion models to calculate this phantom “interest income.” At each rebalance, the PM will sell the bonds that roll off the index due to maturity requirement.

With the proceeds, the PM will purchase new bonds that have just entered the index. However, the PM will purchase slightly fewer new bonds and return some of the proceeds as a cash distribution. Voila! There is your distribution, which can be used to pay your taxes, unless you’re investing through a tax-advantage account such as an IRA account.

The Eye-Popping Performance Of ZROZ And EDV

As the characteristics and attribution analysis has shown, both ZROZ and EDV have very long durations, longer than iShares 20+ Year Treasury Bond ETF (TLT | A-76) and much longer than iShares Core Total U.S. Bond Market ETF (AGG | A-97).

Their long durations thus make them very sensitive to interest-rate changes.

Despite all the talk about rising interest rates, the long end of the yield curve actually came down in the first quarter of 2014, as investors continued to look for extra yield in a low-inflationary environment, and also in a flight-to-safety trade in response to geopolitical unrest in Ukraine.

ZROZ hunts in the 25-plus-year space, while EDV hunts in the 20- to 30-year space. Being the longer-dated of the two, ZROZ has longer duration, and again, is more sensitive to interest-rate changes than EDV and thus benefited more from the drop in yields on the long end of the curve. ZROZ derives more than 95 percent of its return from the changes in the yield curve.

Mean Reversion

But remember, duration can cut both ways. Economic recovery can pick up steam as the impact of severe weathers fades. President Putin might come to his senses for a rational resolution of the crisis in Ukraine. If both scenarios materialize, rates are likely to resume an upward path toward historical norm.

The bottom line: The decline in yields on the long end of the curve so far has benefited long-duration bets such as ZROZ and EDV. But don't get caught chasing performance.

If you already own them, you can probably hold on to them for a bit longer. They might just have a bit more room to run until a confirmed robust economic recovery materializes, or the crisis in Ukraine resolves.

But don’t expect the same impressive performance as the past quarter. If you don’t own them already, think twice. Duration can cut both ways: Just look at their awful performance in the second half of 2013.

At the time this article was written, the author held no positions in the securities mentioned. Contact Howard Lee at [email protected].